Corporate Finance
Questions and Practice problems_Chapter 16
Chapter 16:
Concept questions (page 519 textbook): 3, 4
Questions and Problems (page 520 textbook): 4, 5, 10, 11, 13, 14, 15
PAGE 519
CONCEPT QUESTIONS.
3. MM Propositions In a world with no taxes, no transaction costs, and
no costs of financial distress, is the following statement true, false, or
uncertain? Moderate borrowing will not increase the required return on
a firm’s equity. Explain.
In a perfect world with no taxes, no transaction costs, and no costs of
financial distress
=> required return on a firm's equity would be equal to the risk-free rate plus
the expected return on the market portfolio
because investors would be indifferent between investing in a risky asset and
a risk-free asset, and the only way to induce them to invest in a risky asset
would be to offer them a higher expected return.
Moderate borrowing would increase the riskiness of a firm's equity, so they
would expect the required return on equity to increase
.
However, in a perfect world with no costs of financial distress, the increase in
the required return on equity offset by decrease in the cost of debt.
Because the firm would be able to borrow at a lower interest rate, and the
savings on interest payments would exactly offset the increase in the required
return on equity.
Therefore, in a perfect world, moderate borrowing would increase the
required return on a firm's equity. However, in the real world, there are
always some costs associated with borrowing, and these costs would
increase the required return on equity.
4. MM Propositions What is the quirk in the tax code that makes a
levered firm more valuable than an otherwise identical unlevered
firm?
Interest
payments are tax deductible, whereas payments to shareholders
(dividends) are not tax deductible.
Imagine two companies are exactly the same in how much money they make,
but one has taken out loans and the other hasn’t. The one with loans gets a
special benefit when it pays taxes because it can subtract the interest it pays
on the loans from its income. This means it pays less tax than the company
without loans. So, even though they make the same amount, the company
with loans keeps more of its money after taxes, which makes it worth more.
This special benefit from the tax code is what the Modigliani-Miller
Proposition talks about when it says debt can make a company more
valuable.
PAGE 520
5. We can find the price per share by dividing the amount of debt used to
repurchase shares by the number of shares repurchased. Doing so, we find the share
price is:
Share price = $2,800,000/(265,000 – 185,000)
Share price = $35 per share
The value of the company under the all-equity plan is:
V = $35 * (265,000 shares) = $9,275,000
And the value of the company under the levered plan is:
V = $35 * (185,000 shares) + $2,800,000 debt = $9,275,000
10. MM Nina Corp. uses no debt. The weighted average cost of capital is 9 percent.
If the current market value of the equity is $37 million and there are no taxes, what
is EBIT?
Market value of the equity = $37,000,000
WACC= 9%
no taxes, no debt
Formula:Vu= [EBIT (1- TC)] / R0
=> EBIT = VU *R0
=> EBIT = 37,000,000*9% =$3,330,000
13. Shadow Corp. has no debt but can borrow at 8 percent. The firm’s WACC is
currently 11 percent, and the tax rate is 35 percent. a. What is Shadow’s cost of
equity? b. If the firm converts to 25 percent debt, what will its cost of equity be? c. If
the firm converts to 50 percent debt, what will its cost of equity be? d. What is
Shadow’s WACC in part (b)? In part (c)?
a. For an all-equity financed company:
WACC = Ro = Rs = 0.11 or 11%
b. To find the cost of equity for the company with leverage, we need to use M&M
Proposition II with taxes, so:
Rs = Ro + (B/S)(1 - Tc)(Ro - RB)
Rs = 0.11+(0.25/0.75)(1- 0.35)(0.11- 0.08)
Rs = 0.1165 or 11.65%
c. Using M&M Proposition Il with taxes again, we get:
Rs = Ro + (B/S)(1 - Tc)(Ro - RB)
RS = 0.11+ (0.5/0.5)(0.11- 0.08)(1- 0.35)
Rs = 0.1295 or 12.95%
d. The WACC with 25 percent debt is:
WACC = (S/VL)Rs + (B/VL)RB(1 - Tc)
WACC = 0.75(0.1165) + 0.25(0.08)(1 - 0.35)
WACC = 0.1004 or 10.04%
And the WACC with 50 percent debt is:
WACC = (S/VL)Rs + (B/VL)RB(1 - Tc)
WACC = 0.50(0.1295) + 0.50(0.08)(1 - 0.35)
WACC = 0.0908 or 9.08%
14. MM and Taxes
Bruce & Co. expects its EBIT to be $185,000 every year forever. The firm can
borrow at 9 percent. Bruce currently has no debt, and its cost of equity is 16
percent. If the tax rate is 35 percent, what is the value of the firm? What will the
value be if Bruce borrows $135,000 and uses the proceeds to repurchase shares?
Rb=9%, Rs=16%, Tc=35%.
Value of firm (no debt)
Vu=EBIT/Rs x (1-Tc)=$185,000/16% x (1-35%)
= $715,562
Value of firm when Bruce borrow:
VL=Vu+BTc
= $$715,562 + $135,000 x 35%= $798,812
